Beginners' Guide to
Asset Allocation, Diversification, and Rebalancing
Even if you are new
to investing, you may already know some of the most fundamental
principles of sound investing. How did you learn them? Through
ordinary, real-life experiences that have nothing to do with the
For example, have you
ever noticed that street vendors often sell seemingly unrelated
products - such as umbrellas and sunglasses? Initially, that may
seem odd. After all, when would a person buy both items at the
same time? Probably never - and that's the point. Street
vendors know that when it's raining, it's easier to sell umbrellas
but harder to sell sunglasses. And when it's sunny, the reverse
is true. By selling both items- in other words, by diversifying
the product line - the vendor can reduce the risk of losing money
on any given day.
If that makes sense,
you've got a great start on understanding asset allocation and
diversification. This publication will cover those topics more
fully and will also discuss the importance of rebalancing from
time to time.
Let's begin by looking
at asset allocation.
Asset Allocation 101
Asset allocation involves
dividing an investment portfolio among different asset categories,
such as stocks, bonds, and cash. The process of determining which
mix of assets to hold in your portfolio is a very personal one.
The asset allocation that works best for you at any given point
in your life will depend largely on your time horizon and your
ability to tolerate risk.
||Time Horizon - Your time horizon
is the expected number of months, years, or decades you will
be investing to achieve a particular financial goal. An investor
with a longer time horizon may feel more comfortable taking
on a riskier, or more volatile, investment because he or she
can wait out slow economic cycles and the inevitable ups and
downs of our markets. By contrast, an investor saving up for
a teenager's college education would likely take on less risk
because he or she has a shorter time horizon.
||Risk Tolerance - Risk tolerance
is your ability and willingness to lose some or all of your
original investment in exchange for greater potential returns.
An aggressive investor, or one with a high-risk tolerance,
is more likely to risk losing money in order to get better
results. A conservative investor, or one with a low-risk tolerance,
tends to favor investments that will preserve his or her original
investment. In the words of the famous saying, conservative
investors keep a "bird in the hand," while aggressive investors
seek "two in the bush."
Risk versus Reward
When it comes to investing,
risk and reward are inextricably entwined. You've probably heard
the phrase "no pain, no gain" - those words come close to summing
up the relationship between risk and reward. Don't let anyone
tell you otherwise: All investments involve some degree of risk.
If you intend to purchases securities - such as stocks, bonds,
or mutual funds - it's important that you understand before you
invest that you could lose some or all of your money.
The reward for taking
on risk is the potential for a greater investment return. If you
have a financial goal with a long time horizon, you are likely
to make more money by carefully investing in asset categories
with greater risk, like stocks or bonds, rather than restricting
your investments to assets with less risk, like cash equivalents.
On the other hand, investing solely in cash investments may be
appropriate for short-term financial goals.
While the SEC cannot
recommend any particular investment product, you should know that
a vast array of investment products exists - including stocks
and stock mutual funds, corporate and municipal bonds, bond mutual
funds, lifecycle funds, exchange-traded funds, money
market funds, and U.S. Treasury securities. For many financial
goals, investing in a mix of stocks, bonds, and cash can be a
good strategy. Let's take a closer look at the characteristics
of the three major asset categories.
||Stocks - Stocks have historically
had the greatest risk and highest returns among the three
major asset categories. As an asset category, stocks are a
portfolio's "heavy hitter," offering the greatest potential
for growth. Stocks hit home runs, but also strike out. The
volatility of stocks makes them a very risky investment in
the short term. Large company stocks as a group, for example,
have lost money on average about one out of every three years.
And sometimes the losses have been quite dramatic. But investors
that have been willing to ride out the volatile returns of
stocks over long periods of time generally have been rewarded
with strong positive returns.
||Bonds - Bonds are generally
less volatile than stocks but offer more modest returns. As
a result, an investor approaching a financial goal might increase
his or her bond holdings relative to his or her stock holdings
because the reduced risk of holding more bonds would be attractive
to the investor despite their lower potential for growth.
You should keep in mind that certain categories of bonds offer
high returns similar to stocks. But these bonds, known as
high-yield or junk bonds, also carry higher risk.
||Cash - Cash and cash equivalents
- such as savings deposits, certificates of deposit, treasury
bills, money market deposit accounts, and money market funds
- are the safest investments, but offer the lowest return
of the three major asset categories. The chances of losing
money on an investment in this asset category are generally
extremely low. The federal government guarantees many investments
in cash equivalents. Investment losses in non-guaranteed cash
equivalents do occur, but infrequently. The principal concern
for investors investing in cash equivalents is inflation risk.
This is the risk that inflation will outpace and erode investment
returns over time.
Stocks, bonds, and
cash are the most common asset categories. These are the asset
categories you would likely choose from when investing in a retirement
savings program or a college savings plan. But other asset categories
- including real estate, precious metals and other commodities,
and private equity - also exist, and some investors may include
these asset categories within a portfolio. Investments in these
asset categories typically have category-specific risks. Before
you make any investment, you should understand the risks of the
investment and make sure the risks are appropriate for you.
Why Asset Allocation
Is So Important
By including asset
categories with investment returns that move up and down under
different market conditions within a portfolio, an investor can
protect against significant losses. Historically, the returns
of the three major asset categories have not moved up and down
at the same time. Market conditions that cause one asset category
to do well often cause another asset category to have average
or poor returns. By investing in more than one asset category,
you'll reduce the risk that you'll lose money and your portfolio's
overall investment returns will have a smoother ride. If one asset
category's investment return falls, you'll be in a position to
counteract your losses in that asset category with better investment
returns in another asset category.
Magic of Diversification. The practice of spreading money
among different investments to reduce risk is known as diversification.
By picking the right group of investments, you may be able to
limit your losses and reduce the fluctuations of investment
returns without sacrificing too much potential gain.
In addition, asset
allocation is important because it has major impact on whether
you will meet your financial goal. If you don't include enough
risk in your portfolio, your investments may not earn a large
enough return to meet your goal. For example, if you are saving
for a long-term goal, such as retirement or college, most financial
experts agree that you will likely need to include at least some
stock or stock mutual funds in your portfolio. On the other hand,
if you include too much risk in your portfolio, the money for
your goal may not be there when you need it. A portfolio heavily
weighted in stock or stock mutual funds, for instance, would be
inappropriate for a short-term goal, such as saving for a family's
How to Get Started
Determining the appropriate
asset allocation model for a financial goal is a complicated task.
Basically, you're trying to pick a mix of assets that has the
highest probability of meeting your goal at a level of risk you
can live with. As you get closer to meeting your goal, you'll
need to be able to adjust the mix of assets.
If you understand your
time horizon and risk tolerance - and have some investing experience
- you may feel comfortable creating your own asset allocation
model. "How to" books on investing often discuss general "rules
of thumb," and various online resources can help you with your
decision. For example, although the SEC cannot endorse any particular
formula or methodology, the Iowa Public Employees Retirement System
offers an online asset
allocation calculator. In the end, you'll be making a very
personal choice. There is no single asset allocation model that
is right for every financial goal. You'll need to use the one
that is right for you.
Some financial experts
believe that determining your asset allocation is the most important
decision that you'll make with respect to your investments - that
it's even more important than the individual investments you buy.
With that in mind, you may want to consider asking a financial
professional to help you determine your initial asset allocation
and suggest adjustments for the future. But before you hire anyone
to help you with these enormously important decisions, be sure
to do a thorough check of his
or her credentials and disciplinary history.
The Connection Between
Asset Allocation and Diversification
a strategy that can be neatly summed up by the timeless adage
"Don't put all your eggs in one basket." The strategy involves
spreading your money among various investments in the hope that
if one investment loses money, the other investments will more
than make up for those losses.
Many investors use
asset allocation as a way to diversify their investments among
asset categories. But other investors deliberately do not. For
example, investing entirely in stock, in the case of a twenty-five
year-old investing for retirement, or investing entirely in cash
equivalents, in the case of a family saving for the down payment
on a house, might be reasonable asset allocation strategies under
certain circumstances. But neither strategy attempts to reduce
risk by holding different types of asset categories. So choosing
an asset allocation model won't necessarily diversify your
portfolio. Whether your portfolio is diversified will depend on
how you spread the money in your portfolio among different types
A diversified portfolio
should be diversified at two levels: between asset categories
and within asset categories. So in addition to allocating
your investments among stocks, bonds, cash equivalents, and possibly
other asset categories, you'll also need to spread out your investments
within each asset category. The key is to identify investments
in segments of each asset category that may perform differently
under different market conditions.
One of way of diversifying
your investments within an asset category is to identify and invest
in a wide range of companies and industry sectors. But the stock
portion of your investment portfolio won't be diversified, for
example, if you only invest in only four or five individual stocks.
You'll need at least a dozen carefully selected individual stocks
to be truly diversified.
Because achieving diversification
can be so challenging, some investors may find it easier to diversify
within each asset category through the ownership of mutual funds
rather than through individual investments from each asset category.
A mutual fund is a company that pools money from many investors
and invests the money in stocks, bonds, and other financial instruments.
Mutual funds make it easy for investors to own a small portion
of many investments. A total stock market index fund, for example,
owns stock in thousands of companies. That's a lot of diversification
for one investment!
Be aware, however,
that a mutual fund investment doesn't necessarily provide instant
diversification, especially if the fund focuses on only one particular
industry sector. If you invest in narrowly focused mutual funds,
you may need to invest in more than one mutual fund to get the
diversification you seek. Within asset categories, that may mean
considering, for instance, large company stock funds as well as
some small company and international stock funds. Between asset
categories, that may mean considering stock funds, bond funds,
and money market funds. Of course, as you add more investments
to your portfolio, you'll likely pay additional fees and expenses,
which will, in turn, lower your investment returns. So you'll
need to consider these costs when deciding the best way to diversify
Your Asset Allocation
The most common
reason for changing your asset allocation is a change in your
time horizon. In other words, as you get closer to your investment
goal, you'll likely need to change your asset allocation. For
example, most people investing for retirement hold less stock
and more bonds and cash equivalents as they get closer to retirement
age. You may also need to change your asset allocation if there
is a change in your risk tolerance, financial situation, or the
financial goal itself.
investors typically do not change their asset allocation based
on the relative performance of asset categories - for example,
increasing the proportion of stocks in one's portfolio when the
stock market is hot. Instead, that's when they "rebalance" their
is bringing your portfolio back to your original asset allocation
mix. This is necessary because over time some of your investments
may become out of alignment with your investment goals. You'll
find that some of your investments will grow faster than others.
By rebalancing, you'll ensure that your portfolio does not overemphasize
one or more asset categories, and you'll return your portfolio
to a comfortable level of risk.
let's say you determined that stock investments should represent
60% of your portfolio. But after a recent stock market increase,
stock investments represent 80% of your portfolio. You'll need
to either sell some of your stock investments or purchase investments
from an under-weighted asset category in order to reestablish
your original asset allocation mix.
When you rebalance,
you'll also need to review the investments within each asset allocation
category. If any of these investments are out of alignment with
your investment goals, you'll need to make changes to bring them
back to their original allocation within the asset category.
basically three different ways you can rebalance your portfolio:
- You can
sell off investments from over-weighted asset categories and
use the proceeds to purchase investments for under-weighted
- You can
purchase new investments for under-weighted asset categories.
- If you
are making continuous contributions to the portfolio, you can
alter your contributions so that more investments go to under-weighted
asset categories until your portfolio is back into balance.
rebalance your portfolio, you should consider whether the method
of rebalancing you decide to use will trigger transaction fees
or tax consequences. Your financial professional or tax adviser
can help you identify ways that you can minimize these potential
with Your Plan: Buy Low, Sell High - Shifting money away
from an asset category when it is doing well in favor an asset
category that is doing poorly may not be easy, but it can be
a wise move. By cutting back on the current "winners"
and adding more of the current so-called "losers," rebalancing
forces you to buy low and sell high.
When to Consider
You can rebalance
your portfolio based either on the calendar or on your investments.
Many financial experts recommend that investors rebalance their
portfolios on a regular time interval, such as every six or twelve
months. The advantage of this method is that the calendar is a
reminder of when you should consider rebalancing.
rebalancing only when the relative weight of an asset class increases
or decreases more than a certain percentage that you've identified
in advance. The advantage of this method is that your investments
tell you when to rebalance. In either case, rebalancing tends
to work best when done on a relatively infrequent basis.
Find More Information
For more information
on investing wisely and avoiding costly mistakes, please visit
the Investor Information
section of the SEC's website. You also can learn more about several
investment topics, including asset allocation, diversification
and rebalancing in the context of saving for retirement by visiting
401(k) Investing website as well as the Department of Labor's
Security Administration website.
You can find
out more about your risk tolerance by completing free online questionnaires
available on numerous websites maintained by investment publications,
mutual fund companies, and other financial professionals. Some
of the websites will even estimate asset allocations based on
responses to the questionnaires. While the suggested asset allocations
may be a useful starting point for determining an appropriate
allocation for a particular goal, investors should keep in mind
that the results may be biased towards financial products or services
sold by companies or individuals maintaining the websites.
started investing, you'll typically have access to online resources
that can help you manage your portfolio. The websites of many
mutual fund companies, for example, give customers the ability
to run a "portfolio analysis" of their investments. The results
of a portfolio analysis can help you analyze your asset allocation,
determine whether your investments are diversified, and decide
whether you need to rebalance your portfolio.
We want to
hear from you if you encounter a problem with a financial professional
or have a complaint concerning a mutual fund or public company.
Please send us your complaint using our online Complaint Center. You
can also reach us by regular mail at:
and Exchange Commission
Office of Investor Education and Assistance
100 F Street, N.E.
Washington, D.C. 20549-0213